The short run is a period in which market supply cannot be varied according to change in market demand. It is due to lack of sufficient to vary units or capacity of all inputs. Under perfect competition, an industry is supposed to be a group of firms. When the industry reaches a state of equilibrium, the price of the product is determined. There are two conditions for the industry equilibrium. They are:
a) Market demand equal market supply
b) All firms are in equilibrium.
But under perfect competition, the firm should determine the level of output because it takes its price from the industry. The single firm under perfect competition is regarded as a price taker. The fact that a firm is in equilibrium does not necessarily mean that it makes excess profit. Whether the firm makes excess profit or losses depends on the efficiency of the firm and the level of average cost at the short run equilibrium. These three cases are:
Suppose there are only three firms A, B, and C under a competitive industry. According to figure B, firm A is in equilibrium at a point E1. Thus,
Level of output = OQ1
Price per unit = OP
Total revenue = Area of OPE1Q1
Total cost = Area of OCbQ1
Here area of TR > Area of TC, thus firm A obtains excess profit.
According to figure C, firm B is in equilibrium at a point E2. Thus,
Level of output = OQ2
Price per unit = OP
Total revenue = Area of OPE2Q2
Total cost = Area of OCbQ2
Here area of TR = Area of TC, thus firm B obtains normal profit.
According to figure D, firm C is in equilibrium at a point E3. Thus,
Level of output = OQ3
Price per unit = OP
Total revenue = Area of OPE3Q3
Total cost = Area of OCbQ3
Here area of TR < Area of TC, thus firm C incurs losses.
However, in the long run, firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry and because there is perfect knowledge. The effect of this entry into the industry is to shift the industry supply curve to the right, which drives down the price until the point where all super-normal profits are exhausted. If firms are making losses, they will leave the market as there are no exit barriers, and this will shift the industry supply to the left, which raises the price and enables those left in the market to derive normal profits.
The long run is a period in which market supply can be adjusted according to change in market demand. It is due to the availability of sufficient to vary units or capacity of all inputs. Thus, in the long run, firms are in equilibrium when they have adjusted their plan so as to produce at the minimum point of their long run average cost curve, which is tangent ( at this point) to the demand curve (AR) defined by the market price. In the long run, the firm will be earning just normal profits which are included in the long-run average cost. It is due to the condition of perfect competition i.e. free entry and exit of the firms.
The super normal profit obtained in the short run by the firm turns as an inducement to enter the market for new firms, which increases or raises industry supply and until only normal profit is made, market price falls for all firms.
In the figure, the firm reach in equilibrium at A where a) MC = MR, b) Slope of MC > Slope of MR and c) AR = AC = P. Here, the area of TR (OPAQ) and the area of TC (OPAQ) are equal. Thus, the firm obtains normal profit producing the level of output OQ units. The firm is able to utilize the optimal capacity of its resources. It is shown by the equilibrium point A where long run average cost is minimum.
Benefits of the perfect competition
It can be claimed that perfect competition will harvest the following welfares or benefits:
Very few markets or industries in the real world are perfectly competitive. For example, how homogeneous is the output of real firms, given that even the smallest of firms working in manufacturing or services try to differentiate their product.
The assumption that producers and consumers act rationally is questioned by behavioral economists, who have become increasingly influential over the last decade. Numerous experiments have demonstrated that decision-making often falls well short of what could be described as perfectly rational. Decision making can be biased and subject to the rule of thumb ‘guidance’ when consumers and producers are faced with complex situations.
Although unrealistic, it is still a useful model in two respects. Firstly, many primary and commodity markets, such as coffee and tea, exhibit many of the characteristics of perfect competition, such as the number of individual producers that exist, and their inability to influence market price. Secondly, for other markets in manufacturing and services, the model is a useful yardstick by which economists and regulators can evaluate levels of competition that exist in real markets.
Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan